Published: October 11, 2011 at 11:08 am

Investors have looked to Morningstar (MORN) for years for financial advice, but a new lawsuit is challenging those calls.

In the suit, there individual investors claim that they lost more than $75,000 each on Morningstar’s glowing ratings of the now defunct Life’s Good Stabl Mortgage Fund. Life raised $16 million from investments made by over 140 investors. It was supposed to be a fund specializing in short-term commercial mortgage loans and turning annual returns between 10-16%. Instead, thefund was operating as a Ponzi scheme. The SEC is involved.

So, What’s the Story, Morningstar?

The SEC obtained a primary judgment on June 20, 2011 from a Pennsylvania federal court. Morningstar argues that its ratings should be used as a starting point for investor research – not function as hedge fund gospel. Further, hedge funds are mostly private investment pools. So, agencies like Morningstar can only base its rating on data the fund provides. Morningstar does have a system in place for detecting operational red flags, like not using an independent auditor. Life was flagged in 3 out of 4 areas.

So, Morningstar is to Blame for the Losses?

The firm’s head of research, Don Phillips, acknowledges the rating system for hedge funds is limited, but does that really mean that Morningstar is to blame for the investors’ losses? According to SmartMoney, when Morningstar gives a fund a higher rating, that fund ends up receiving a disproportionately large amount of investor dollars. Some of this comes from individual investor seeking out the funds that Morningstar recommends most highly, while the remaining volume stems from fund managers that market funds with Morningstar ratings more aggressively.

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